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Sustaining Price Stability

J. Alfred Broaddus, Jr. and Marvin Goodfriend The year 2003 was a watershed in Federal Reserve history. In his semiannual testimony to Congress on monetary policy in July, Chairman Greenspan declared that measures of core consumer inflation had decelerated in the first half of the year to a range that could be considered “effective price stability.”1 FRB_Text_Printer 8.625 6/9/04 8:51 AM Page 5

The Chairman paused briefly to acknowledge, with understated satisfaction, the achievement of this goal, which Congress had assigned to the Federal Reserve, and the Fed had pursued for over two decades. He quickly pointed out, however, that the Fed would be confronted now with new chal- lenges in sustaining price stability—specifically preventing deflation as well as inflation. Earlier in the year, at the conclusion of its May meeting, the Federal Open Market Committee (FOMC) had expressed concern for the first time that inflation might decline too far, saying that “the probability of an unwelcome substantial fall in inflation, though minor, exceed(ed) that of a pickup in infla- tion from its already low level.”2 The case for maintaining price stability—in the United States and elsewhere—is rooted in experience and theory,which indicate that mon- etary policy best supports employment, economic growth, and financial stability by making price stability a priority.The full rationale for price sta- bility has been elaborated elsewhere, and we will refrain from repeating it here.3 This article, instead, is about how to sustain price stability now that it has been achieved.We build our argument in several stages. First, we present a framework for under- standing the inflation and deflation processes.

The authors are respectively president, and senior vice president and policy advisor. The views expressed are the authors’ and not necessarily those of the Federal Reserve System. FRB_Text_Printer 8.625 6/9/04 8:51 AM Page 6

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Our framework, borrowed from the “new neoclas- effective communication is a crucial ingredient in sical synthesis”macroeconomic model, focuses on building and maintaining credibility for price the management of the markup of price over mar- stability.Good communication requires clear ginal cost by monopolistically competitive firms.4 long-run policy objectives and clarity in conveying Next, we provide examples of shocks that are the reasoning behind short-run policy actions potentially inflationary or deflationary and aimed at achieving those objectives. In line with explain how interest rate policy actions can coun- our macroeconomic framework, we believe that teract them effectively to maintain price stability. both purposes would be well served if the Fed pub- The Fed’s current licly announced an explicit hard-won credibility for long-run inflation target, low inflation is a founda- “The fundamental and made more prominent tion of efficient monetary principle of price use of price-cost gap, policy because it anchors stability …[is that] employment gap, and expected inflation.We inflation will remain low output gap indicators in review briefly why inflation and stable if and only if explaining the stance of scares create problems for departures from profit- monetary policy.In par- monetary policy. Addressing ticular, we explain how,in maximizing markups are the challenge noted by our view,these changes expected to be relatively Chairman Greenspan, we would help minimize the explain why deflation scares small and transitory kind of communication are equally problematic. across firms.” problems the Fed faced in Unfortunately,credibility 2003 in signaling its con- for containing inflation does not necessarily imply cern about deflation and its policy intentions for credibility against deflation because while there is dealing with the rising risk of deflation at that time. no upper bound on nominal interest rates to resist Having outlined what we want to accomplish inflation, there is a lower bound at zero.We explain in this article, let us emphasize that what follows how the Fed can use monetary policy—even at the is our understanding of the issues and our sugges- zero bound—to preempt deflation and acquire tions for dealing with them. Some of our views are credibility against deflation to complement its shared by our Fed colleagues, others are not. This anti-inflation credentials. is no cause for embarrassment. Monetary policy Communication has come to play an increas- and its effect on the economy is a complex and ingly important and substantive role in the Fed’s subtle subject; there is plenty of room for different conduct of monetary policy because open and approaches and divergent views. FRB_Text_Printer 8.625 6/9/04 8:51 AM Page 7 FRB_Text_Printer 8.625 6/9/04 8:51 AM Page 8

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The Fundamental Principle Potential inflation arises when a significant of Price Stability compression of markups is widely expected by Our approach to thinking about the maintenance firms to persist. In this case, firms raise product of price stability focuses on how monopolistically prices over time to cover higher expected costs. competitive firms set their prices over time.5 Potential deflation develops if firms expect signifi- This approach is useful because it highlights cantly elevated markups to persist. Competition how monetary policymakers must create an for product market share in this latter case induces environment within which firms choose to firms to pass along lower costs via lower prices. maintain stable prices on average.6 Such reasoning implies the fundamental For our purposes, a key feature of price- principle of price stability: inflation will remain setting in practice is its discontinuous character. low and stable if and only if departures from It is costly for a firm producing a distinctive profit-maximizing markups are expected to be product to determine the exact price that relatively small and transitory across firms, so maximizes its profits at every point in time. firms are content to raise prices at the existing Forecasts of demand and cost conditions are low inflation rate on average. Note that we con- expensive to obtain. Moreover, pricing must sider low and stable inflation to be “effective compete with other claims on management’s time, price stability,”in keeping with Chairman such as production and marketing decisions. Greenspan’s characterization. Consequently,pricing gets the attention of The historical record shows that in the long management only every so often. run competition among firms for labor pushes For all these reasons, a firm is apt to consider real wages (nominal wages adjusted for inflation) changing its product price only when demand up at about the same rate as labor productivity and cost conditions threaten to move its actual grows. Consequently,real production costs in the markup of price over cost significantly and aggregate are stable in the long run. Nominal persistently away from its profit-maximizing wages, in turn, tend to rise at the rate of produc- markup.7 Given a firm’s current product price, tivity growth plus the rate of inflation; therefore, higher production costs compress its markup, nominal production costs rise at about the rate and lower production costs elevate its markup. of inflation in the long run. In the short run, Production costs, in turn, increase with the hourly however, shocks to aggregate demand and pro- wage a firm must pay its workers and decrease ductivity can cause production costs to vary as labor productivity (output per hour) rises.8 significantly and persistently relative to prices. FRB_Text_Printer 8.625 6/9/04 8:51 AM Page 9

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Counteracting Shocks therefore a compression of the average markup to Price Stability that inclines firms to raise prices above the pre- This section builds on the fundamental principle viously expected low inflation rate unless the of price stability discussed in the previous section Fed uses interest rate policy actions to reverse to explain how monetary policy,working through the increase in costs and the markup compres- short-term interest rates, can counteract inflation- sion. A deflationary shock, in contrast, generates ary or deflationary shocks to the economy.The a sustained deceleration or decline in production argument is straightforward: interest rate policy costs, and an increase in the markup that maintains price stability by managing aggregate requires offsetting Fed interest rate actions. demand so as to stabilize the actual markup at Exactly how interest rate policy works to stabi- the profit-maximizing markup on average across lize the markup is explained below. firms.9 (What follows is tightly reasoned but well For expositional purposes, it is useful to worth working through, since it describes the divide shocks with inflationary or deflationary core relationships policymakers must focus on potential into two categories. We consider first to succeed in maintaining price stability.) shocks to expected future income prospects. An inflationary shock generates a sus- Subsequently,we take up shocks to current tained acceleration in production costs, and productivity growth.

10

8

6

4 Year-Over-Year Percent Change Year-Over-Year

2

0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

CORE PCE PRICE INDEX Source: Bureau of Economic Analysis

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Shocks to Expected Future whichever the case may be. Clearly,it is better that Income Prospects profit-maximizing markups be restored by interest Whatever the source of optimism or pessimism rate policy actions without inflation or deflation. about the future, shocks to expected future wages Bottom line: the Fed can offset a potentially and profits are likely to be transmitted to current inflationary increase in current demand arising from aggregate demand.10 Households will want to an increase in expected future income prospects by adjust current as well as future consumption to raising real interest rates to increase the return to reflect any changes in expected lifetime resources. saving, raise the cost of borrowing, and induce And firms will want to households and firms to invest more or less cur- defer spending. Higher real rently in response to “Profit-maximizing rates preempt inflation by any changes in expected markups will be reversing the increased cur- future profits. restored.… the Fed must rent demand for labor, which In these circum- restore …[them] promptly reduces the pressure on stances, optimism about wages and production costs, with interest rate policy future income prospects is and restores profit-maximiz- actions,or else firms will potentially inflationary ing markups. Conversely,by because it increases the attempt to restore … lowering real interest rates, current demand for labor, [them] by raising or the Fed can lower the return raises wages, and com- cutting product prices.” to saving and the cost of presses markups. On the borrowing, stimulate spend- other hand, pessimism ing, and offset a potentially about future prospects is potentially deflationary deflationary reduction in aggregate demand. Lower because it eases competition in the labor market, real rates, in turn, preempt deflation by strengthen- slows wage growth, and elevates markups. ing current labor demand, reversing the downward The key point for monetary policy is this: pressure on wages, and recompressing markups. one way or another, profit-maximizing markups The argument above proceeded as if firms will be restored. The shock may dissipate before were not fully confident that the Fed would act inflationary or deflationary forces build up. If not, promptly to stabilize production costs that would then either the Fed must restore profit-maximizing otherwise be affected by shocks to future income markups promptly with interest rate policy prospects. If firms are confident, then they will actions, or else firms will attempt to restore these meet a temporary increase in demand by working markups by raising or cutting product prices, current employees more intensively or by hiring FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 11

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temporary workers, rather than by raising product effects are particularly noteworthy.Surprisingly prices. And firms will lay off labor rather than cut persistent strong productivity growth in conjunction prices if they expect the Fed to stabilize production with a weak labor market helped lower production costs in the face of a shortfall in current demand. costs and produce disinflation in 2003. Conversely, Note that the average markup will tend to be com- surprisingly persistent weak productivity growth pressed temporarily in the first case and elevated helped produce inflation in the 1970s.11 temporarily in the second case.We will say more The longer a surprising acceleration or deceler- below about why the Fed’s“credibility” for price sta- ation of productivity growth persists, the more bility is the foundation of likely it will come to be efficient monetary policy. expected to persist. If these changes in expectations are Shocks to Current sufficiently pronounced, Productivity Growth they have the potential to Consider next a sequence offset and reverse the ini- of current shocks to pro- tial risk to price stability ductivity growth that arising from the change in persist unexpectedly at productivity growth. This first, but subsequently appears to be what hap- come to be expected to pened in the late 1990s persist. Initially,unantici- when surprisingly persistent pated increases in pro- increases in productivity ductivity growth are growth apparently came to potentially deflationary,and decreases are be expected and were extrapolated far into the future. potentially inflationary.We take the deflationary The brightening future income prospects caused case; the inflationary case is exactly the reverse. aggregate demand to grow even faster than produc- For a given growth rate of wages, accelerated tivity for a time near the end of the decade. Labor productivity growth lowers production costs markets tightened, real wages grew about as fast as directly. If, at first, the acceleration is not expected productivity,and inflation remained low and sta- to persist, there is little effect on expected future ble. Indeed, there was concern at the time that income and little effect on current aggregate inflation might rise if the increase in demand stim- demand. In such circumstances, faster productivity growth also slows production costs indirectly by ulated by the higher expected future income reducing current labor demand and slowing the growth outstripped the restraining effect of the growth of wages. Two historical examples of these higher productivity growth on prices. FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 12

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Whether current shocks to productivity are enough; estimating and tracking indicators of the potentially inflationary or deflationary,the Fed average profit-maximizing markup is even more so. can act to offset that potential with interest rate Modeling the transmission of interest rate policy policy. Again, the guiding policy principle is to actions to demand, production costs, and inflation manage aggregate demand to stabilize production requires sophisticated econometric techniques. And costs so as to sustain profit-maximizing markups discerning whether the public perceives an increase on average. The Fed must reduce real interest rates in productivity growth as transitory or more last- to defuse the potential for deflation when a period ing, for example, is not easy.Tasks like these are as of faster productivity challenging as they are growth is not expected to crucial. Some would refer persist. In this situation, “Credibility for stable to the judgements involved lower real interest rates prices… anchors in this work as the “art”of must stimulate aggregate inflation expecta- monetary policy. demand sufficiently to tions… buys time for offset the weakness in labor The Importance the Fed to recognize and markets and thereby allow of Credibility wage increases to reflect counteract threats to for Stable Prices the higher productivity. price stability.…[and] As the foregoing has already Alternatively,if the public enhances the flexibility suggested, credibility is an comes to regard a period of interest rate policy.” of faster productivity essential component of growth as an increase in effective monetary policy.

trend growth, then the Fed might have to increase The long campaign from the late 1970s through

real interest rates to relieve the potential for inflation. the early 1990s to reduce inflation and establish Specifically,interest rates would have to rise enough price stability arguably succeeded only when the to limit the increase in current aggregate demand Fed finally acquired credibility for low inflation in to what can be satisfied by the current increase in the eyes of the public in the late 1990s. Indeed, the productivity at the profit-maximizing markup. acquisition of this credibility was essentially Having outlined these policy prescriptions, equivalent to establishing price stability—two we want to be quick to acknowledge—as practical policymakers—that implementing them with con- ways to describe the same achievement. Similarly, sistent success is far from rote. Measuring and pre- the Fed needs to acquire credibility for sustaining dicting the relevant aggregate variables is difficult price stability going forward. FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 13

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The previous section showed how interest unchanged; but that would do nothing to reverse rate policy actions can counteract inflationary the collapse of confidence. or deflationary shocks and perpetuate credibility Inflation scares are dangerous because presuming that it has already been established. ignoring them encourages even more doubt about In this section we explain why full credibility for the Fed’s commitment to low inflation. And maintaining price stability is so useful, and how restoring credibility for low inflation requires the its absence can cause serious problems. Fed to weaken labor markets deliberately with Credibility for stable prices produces three higher real interest rates in order to slow wage critically important benefits. First, credibility growth, elevate markups, and induce firms not to anchors inflation expectations so that nominal raise prices—rarely a popular policy stance with federal funds rate target changes translate clearly the public or the political establishment. It is in into real interest rate changes, which helps the Fed large part to avoid the risk of recession posed by gauge the likely impact of its policy actions on the inflation scares that the Fed has learned to preempt economy.Second, credibility buys time for the Fed to inflation with interest rate policy. recognize and counteract threats to price stability. Unfortunately—and this is a crucial point in Third, credibility enhances the flexibility of interest appreciating fully the policy implications of the rate policy to respond aggressively to transitory transition from fighting for price stability to shocks that threaten to destabilize financial markets maintaining it—credibility for controlling inflation and create unemployment. does not automatically translate into credibility The absence of credibility,on the other hand, for preventing deflation. A deflation scare obviously creates problems for monetary policy.The history does not confront the Fed with a choice between of post-World War II monetary policy in the United contracting employment and losing credibility. States features numerous inflation scares marked by On the contrary,the way to resist a deflation scare sharply rising long-term bond rates reflecting is to reduce real interest rates in order to stimulate increased expected inflation premia.12 Inflation demand, tighten labor markets, raise wages, and scares create a fundamental dilemma for monetary compress the markup. The problem is that given the policy.At the initial nominal federal funds rate zero bound on the nominal federal funds rate, interest target, higher expected inflation lowers the real rate policy alone might have insufficient leeway to federal funds rate and intensifies the inflation deter deflation, especially since the federal funds scare by stimulating current aggregate demand rate is low on average when expected inflation is low. and compressing the markup. In these circum- Moreover, the Fed would have to drive the nominal stances, the Fed could raise its nominal federal federal funds rate ever closer to zero to prevent funds rate target just enough to leave the real rate disinflationary expectations from raising the real FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 14

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federal funds rate. And deflation expectations could lower potential GDP substantially.13 In would actually raise the real federal funds rate at doing so, they would lower future income prospects, the zero bound and exacerbate the deflation scare. lower current aggregate demand, contract current In addition, a policy vacuum at the zero employment, lower wages and production costs, bound could encourage ill-advised fiscal actions. and exacerbate the deflation problem. This Some fiscal actions would be desirable as we explain appears to be what happened in the Great below; but many would not be. For instance, the Depression of the 1930s.14 government might enact legislation that results in Ultimately then, a deflation scare, like an wasteful government spending, inefficient credit inflation scare, is problematic because it has the subsidies, or forbearance in the banking system potential to lead to a protracted recession. From related to deposit insurance. The government might this perspective, even those who care mainly also resort to off-budget policies such as anti- about employment and output can understand competitive measures to support wages or prices why the Fed must establish credibility as a in particular sectors. All told, such fiscal actions deflation fighter as well as an inflation fighter FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 15

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by making price stability a priority and resisting But how,specifically,can the Fed confront a deviations from it in either direction. deflationary risk when the funds rate is at the zero Moreover, credibility against inflation and bound? Most importantly in our view,the Fed can credibility against deflation are mutually supportive: continue to inject money into the economy by each strengthens the other, and each is weaker buying assets and expanding its balance sheet when without the other.15 As we pointed out above with conventional interest rate policy is immobilized at respect to inflation scares, policy must compensate the zero bound.17 Some economists believe that for insufficient credibility in one direction by tak- expanding the monetary base would stimulate ing risks in the other direction.We make this spending directly through a monetarist channel of point again as it pertains monetary transmission. to establishing credibility Others focus on how Fed against deflation. “Monetary policy must purchases of long-term bonds would stimulate be able to defeat deflation Defeating spending by lowering long- at the zero bound; other- Deflation at term interest rates. Still the Zero Bound wise, the government others believe that But how can the Fed could eliminate explicit expanding the balance establish credibility for taxes and finance all sheet would work by creat- preventing deflation of its expenditure ing expectations of infla- given the zero bound on forever with money tion that would push real the nominal funds rate? created by the Fed!” interest rates below zero if In brief, the Fed should the Fed held the nominal make arrangements to federal funds rate at zero. overcome operational and institutional obsta- Even though we do not know the relative cles identified below that could impede the strength of these three transmission channels, and effectiveness of monetary policy at the zero others that may exist, we do know this: monetary bound. The publication of a contingency plan policy must be able to defeat deflation at the zero for the aggressive pursuit of monetary policy bound; otherwise, the government could eliminate against deflation at the zero bound would greatly explicit taxes and finance all of its expenditure for- reduce the likelihood and force of deflation ever with money created by the Fed!18 The challenge scares and help guarantee that the devastating is to identify and overcome operational and institu- effects of deflation experienced earlier in U.S. tional obstacles to the credible implementation of history will not be repeated.16 quantitative monetary policy as opposed to interest FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 16

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rate policy,where “quantitative monetary policy” To lock in credibility against deflation, however, refers to open market purchases that expand the the Fed will need more fiscal support for quan- volume of assets and monetary liabilities on the titative policy at the zero bound than it is usually Fed’s balance sheet. granted by the fiscal authorities, i.e., Congress and What are these operational and institutional the Treasury.For example, in some circumstances, obstacles? One problem is that the bang for the buck of there might not be enough outstanding longer- quantitative monetary policy at the zero bound is term government bonds to purchase, or govern- unknown and may be relatively weak. It follows that ment budget deficits to monetize, to make the the Fed must be prepared, quantitative policy effec- if necessary,to overshoot tive. Of course, the Fed temporarily the long-term, could buy other assets. steady state size of its bal- “To lock in credibility But buying domestic pri- ance sheet by a wide margin. against deflation ... the vate assets or foreign But to do so, the Fed must Fed will need more assets on the large scale have a credible exit strategy fiscal support for quanti- contemplated here would for draining whatever create other credibility tative policy at the zero monetary base threatens problems.20 Additionally, bound than it is usually excessive inflation after it this strategy would has successfully concluded granted by ... Congress expose the Fed to capital its deflation-fighting and the Treasury.” losses that might leave it policy actions. with insufficient assets to A second problem is reverse a huge expansion that short-term government securities are perfect of its balance sheet, should that be required.21 substitutes for the monetary base at the zero The fiscal authorities could enter the process bound; therefore, the Fed would have to buy longer- in a number of ways. In particular, they could support term government securities, private assets, or foreign the Fed’s exit strategy by committing to transfer assets for quantitative policy to be effective at the enough government securities to the Fed—in effect zero bound.19 The current outstanding stock of to recapitalize the Fed if necessary—to allow the longer-term government securities together with Fed to drain whatever base money needed to be the prospective flow of future government borrow- withdrawn from the economy following an aggres- ing may very well provide sufficient government sive anti-deflation action by the Fed at the zero securities for the Fed to buy—that is, monetize—to bound. In addition, the fiscal authorities could defeat deflation at the zero bound. agree to run a budget deficit to help inject money FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 17 FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 18

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into the economy.The Fed could monetize short- stability. First, the Fed can lock in long-run price term debt issued to finance the deficit and then stability and clarify its short-run concerns and withdraw excess base money later by selling the policy intentions regarding inflation by publicly debt back to the public. In this way,monetary announcing an explicit low long-run inflation target. policy could be made completely credible against Second, the Fed can clarify its reasons for taking deflation in virtually any situation. particular short-run policy actions to preempt This discussion may strike some readers as potential inflation or deflation by talking in terms far-fetched. But while the probability is low that a of the average gap between the actual markup and deflationary threat of the magnitude contemplated the profit-maximizing markup, and closely related here at the zero bound will emerge in the future, if indicators of labor market tightness, which we it did, the consequences of not being fully prepared identified earlier as the proximate determinants to deal with it could be exceptionally damaging to of price pressures. Our arguments for these two the economy.Consequently,we believe it is essen- recommendations are developed below. tial to have contingency arrangements of the kind we have just described firmly in place in advance. Clarifying Short-Run Policy Aims with an Inflation Target

Improving Communication in Although the Fed has made price stability a priority Support of Price Stability for monetary policy,it does not publicly and explic- Up to this point, we have explained the economics of itly specify a target range for inflation. Instead, maintaining price stability in the context of a modern the Fed signals its concerns about inflation or deflation macroeconomic model, and indicated the critical in its post-FOMC meeting statements and minutes, importance of credibility in this effort, including and in the Chairman’s monetary policy reports to credibility for confronting the risk of deflation at the Congress.We believe that the Fed’s experience in the zero bound. This last section of our article addresses May–June 2003 period indicates that references to a final element in the strategy for maintaining price inflationary or deflationary risks cannot reliably stability: clear communication with the public substitute for an explicit long-run inflation target. regarding both the strategy itself and short-term The indication in the announcement follow- actions taken in the defense of price stability.22 ing the May 2003 FOMC meeting that significant The macroeconomic model of the inflation further disinflation would be unwelcome, in our and deflation processes outlined above suggests view,effectively put a lower bound on the Fed’s two substantial opportunities for the Fed to tolerance range or comfort zone for inflation. At improve its communication practices in ways that the time, inflation was running at around 1 percent would strengthen its strategy for maintaining price in terms of the core PCE, one of the Fed’s preferred FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 19

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inflation measures.23 The assertion of a lower a policy action taken out of context, and, there- bound seemed prudent given the deflation risk fore, it is particularly difficult for the Fed to pre- discussed above and the fact that the federal dict the effect of an unsystematic policy action.25

1 funds rate at the time was 1 ⁄4 percent. The Fed’s We think this reasoning extends to policy statement served two useful purposes—it alerted announcements as well. Since the ad hoc implicit the public to the small but real risk of deflation announcement of a lower bound on the Fed’s while also asserting implicitly that the Fed would tolerance range for inflation was unsystematic by act to deter further disinflation. definition, it is not surprising that the announce- The assertion of the ment caused confusion, lower bound on inflation, nor that the Fed failed however, came as a surprise to predict the public’s that took the expected reaction. In this case the future path of the federal reaction was excessive, funds rate sharply lower but in another situation and pulled longer-term there might have been an interest rates down as insufficient reaction. well. Commentary in the If an inflation target media amplified nervous- range had been in place in ness about deflation well 2003, the public could beyond what was justified have inferred the Fed’s in the economic data. In growing concern about the event, the Fed reduced disinflation as the infla- its federal funds rate target only 25 basis points, tion rate drifted down toward the bottom of the rather than the widely anticipated 50 basis points, range through the first half of the year. Expected at the June FOMC meeting.And longer-term inter- future federal funds rates and longer-term interest est rates promptly reversed field.24 rates would have moved lower continuously,with Our reading of this episode is that references less chance of overshooting or undershooting the to the probability of rising or falling inflation in Fed’s intended policy stance.We recommend that FOMC policy statements cannot reliably substi- the Fed publicly commit to maintaining core PCE tute for an announced, explicit inflation target inflation within a target range of 1 to 2 percent range. One of the most important lessons of over the long run so that such misunderstandings rational expectations theory is that it is particu- won’t recur at either end of the Fed’s tolerance larly difficult for the public to gauge the intent of range for inflation.26 FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 20

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The Fed’s assertion of an inflation target Clarifying Short-Run might appear to some to usurp a congressional Policy Aims with Gap Indicators prerogative.We think otherwise for three reasons. The second opportunity for improved communi- First, we believe a compelling case can be made cation noted above is more effective explanation of that, beyond underlining the Fed’s long-term respon- the reasons for particular short-term policy actions. sibilities for price stability,an inflation target would The macroeconomic framework presented above be a valuable addition to the Fed’s operational com- locates the potential for departures from price sta- munications procedures. From this perspective, we bility in the sign, size, and expected persistence of believe that at least implic- the average price-cost gap itly Congress has already between actual markups delegated authority to set and the respective profit- an inflation target to the maximizing markups. In “We recommend Fed as part of its opera- practice, indicators of the that the Fed publicly tional independence. employment gap and the Second, as we empha- commit to maintaining output gap are also used, in sized earlier, monetary core PCE inflation conjunction with prefer- policy best facilitates within a target range able but hard-to-measure achievement of the Fed’s of 1 to 2 percent over price-cost gap indicators, other mandated policy the long run.” to assess the risks to price goals—such as maximum stability.28 (Recall that sustainable employment, tightness or slack in the economic growth, and labor market is what causes financial stability—by making price stability a priority. nominal wages to accelerate or decelerate. Markup Third, an inflation target would not prevent dynamics then govern the transmission of these or hinder the Fed from taking the kinds of policy nominal wage dynamics to the price level.) Recently, actions it takes today to stabilize employment and the Fed has mentioned only the growth of output output in the short run.What it would do is to or productivity,and the improvement or deteriora- discipline the Fed to ensure that these actions are tion in employment in its policy statements, and consistent with its commitment to protect the has rarely if ever mentioned markups, price-cost purchasing power of the currency.27 gaps, or employment and output gaps. FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 21

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We recognize that gap indicators are particu- when calling attention to employment and output larly difficult to estimate, especially in real time. gaps created pressure that ultimately led to infla- One must measure the average markup, aggregate tionary monetary policy and very poor macroeco- employment and output and estimate the time-vary- nomic performance.29 Even so, Fed economists ing levels of these aggregates believed to be consistent necessarily employ,internally at least, implicit with price stability. And one must forecast future estimates of the price-cost gap, the employment changes in these gap indicators in order to assess the gap, and the output gap to evaluate the potential risks to price stability.Furthermore, one must decide for inflation or deflation. Therefore, gaps ought to how to weight the various indicators in the overall be mentioned more prominently in the Fed’s assessment when inevitable inconsistencies occur. post-FOMC policy statements and other impor- There is a natural reluctance to feature gaps tant regular policy reports such as the FOMC in the Fed’s policy statements because of the meeting minutes and the semiannual monetary unfortunate experience in the 1960s and ’70s, policy reports to Congress.30 This would help to FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 22

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avoid confusion in periods such as the recent past Summary and Conclusion when productivity growth has been rising and In this article, we have sought to provide a frame- fluctuating widely with substantial effects on work for thinking about how monetary policy can employment and production costs. maintain price stability.The core principle—taken In the second half of 2003 the Fed had diffi- from the new neoclassical synthesis—is that infla- culty convincing financial markets of its inclination tion will remain low and stable if and only if firms, to maintain a low federal funds rate for a “consid- on average across the economy,expect departures erable period.”31 One reason for this, in our view,was from their profit-maximizing markups to be rela- that its policy statements emphasized explicitly tively small and transitory.We explained how strong real economic growth during the period but interest rate policy works to maintain price stabil- paid insufficient attention to the sizable gap in ity by managing aggregate demand to offset the employment and the cumulative deflation in unit effect on production costs of shocks to expected labor costs that had almost certainly widened the future income prospects and current productivity. price-cost gap. The apparent size and likely persis- Monetary policy is most effective when the tence of these gaps produced the disinflation that public is confident that the Fed will act to stabilize occurred in 2003 and constituted the deflation risk that production costs promptly after a shock—what we inclined the Fed to keep the federal funds rate low. referred to as “credibility”for price stability.When To sum up, we believe that the Fed has much the Fed has credibility,prices are relatively insensi- to gain and little to lose by referring to price-cost, tive to cost shocks on average, since firms expect employment, and output gaps more prominently.32 the Fed to manage aggregate demand to reverse By communicating more explicitly in terms of gap pressures on costs in either direction promptly. indicators, the Fed could clarify substantially its Credibility anchors expected inflation and enables views regarding inflationary or deflationary risks the Fed to act aggressively to prevent recessions. and make expected future federal funds rates conform On the other hand, we indicated how the absence more closely to its preemptive policy intentions. If the Fed clarifies its short-run policy aims of credibility raises the risk of recession whenever with gap indicators, however, it is critical that it also the economy is confronted with either an inflation discipline itself by announcing an explicit long-run scare or a deflation scare. inflation target to deal with any inconsistencies The Fed’s current credibility as an inflation that may appear between gap indicators and infla- fighter is now firmly established, but the zero tion performance. The Fed should acknowledge its bound on interest rate policy impedes the exten- definition of price stability to avoid repeating sion of that credibility,in any straightforward way, either the inflationary mistakes of the 1960s and to deflation.We pointed out, however, that ulti- ’70s or the deflationary mistakes of the 1930s. mately monetary policy must be able to deter FRB_Text_Printer 8.625 6/9/04 8:52 AM Page 23

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deflation at the zero bound; otherwise, the govern- Second, the sign, size, and expected persis- ment could eliminate explicit taxes and finance all of tence of price-cost, output, and employment gap its expenditure forever with money created by the Fed. indicators play a central role in gauging the risks We identified several operational and institu- to price stability and in preempting inflation and tional obstacles that the Fed should address to deflation.We recommend that the Fed feature make quantitative policy (as opposed to interest such gap indicators more prominently in its state- rate policy) credible against deflation at the zero ments and discussions about policy to clarify the bound. In particular, we pointed out that in order potential for inflation or deflation in its outlook, to secure full credibility and to clarify its inten- against deflation, the Fed tions for dealing with will need more fiscal sup- “Fed economists necessarily these threats.We empha- port for quantitative poli- employ ... implicit size that the Fed should cy at the zero bound than estimates of the price-cost announce an explicit is usually granted by the gap,the employment gap, inflation target so that it fiscal authorities. and the output gap … does not stray far from Finally,we offered price stability under Therefore, gaps ought to two recommendations any circumstances. be mentioned more for improving the Fed’s The role of monetary communication policy prominently in the policy in halting what designed to address the Fed’s post-FOMC seemed to be an inexorable kinds of problems the Fed policy statements.” rise in inflation in the faced in conveying its con- 1970s, and subsequently cerns about deflation last year. First, the Fed reducing it during the ’80s and ’90s to an accept- should commit publicly to maintaining core PCE able level, is in our view one of the greatest inflation within a target range of 1 to 2 percent achievements in the Fed’s history.We hope that over the long run.We think that an inflation target our article will help the Fed to surmount its next should be regarded, not just as a policy goal, but challenge—the maintenance of price stability— as an essential part of communication policy. in the years ahead.

Robert Hetzel, Jeffrey Lacker, Bennett McCallum, Aaron Steelman, and John Walter contributed valuable comments to this article. FRB_Text_Printer 8.625 6/9/04 8:53 AM Page 24

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ENDNOTES

1. See Greenspan (2003), page 5. 16. Deflations in the early 1920s and in the 1930s were particularly destruc- tive; milder deflations at other times caused less distress. 2. See Bernanke (2003) for a discussion of the nature of the deflation risk. 17. The Fed is not free to expand the size of its balance sheet as long as it 3. See, for instance, Goodfriend and King (2001), and Goodfriend (2004). targets a federal funds rate even slightly above zero. In that case, the size of its balance sheet is constrained to create a scarcity of bank reserves 4. New neoclassical synthesis (NNS) models feature complete microeco- just sufficient to maintain the desired positive federal funds rate. nomic foundations as in real business cycle economies and imperfect competition and sticky prices as in New Keynesian economies. New 18. Technically,a deflation trap is not a possible rational-expectations equilib- synthesis models are thoroughly discussed and analyzed in Goodfriend rium if the nominal value of total government liabilities will not decline, and King (1997, 2001) and Woodford (2003).The Federal Reserve even in the presence of sustained deflation. See Woodford (2003),page 133. Board’s FRB-U.S. macromodel shares many of the central features of the NNS approach (see Brayton et al. [1997]), as does the model of mon- 19. When the federal funds rate has been pushed to zero, there is no oppor- etary policy discussed extensively in Clarida, Galí, and Gertler (1999). tunity cost to holding currency or bank reserves relative to short-term securities. Hence, the public is indifferent at the margin between holding 5. Monopolistically competitive firms have the market power to set their cash or short-term securities, and open market purchases of short-term product price above the marginal cost of production. securities have no effect.

6. The term “on average”is important. Obviously,individual firms adjust 20. See Broaddus and Goodfriend (2001). particular prices in response to sector- and firm-specific demand and supply conditions as well as the broader pricing environment. 21. For instance, long-term bonds purchased to stimulate the economy when interest rates are near zero suffer large capital losses when interest 7. An excessively high markup is counterproductive because it yields too rates rise as the economy recovers. much market share to competitors; conversely,a markup that is too small does not exploit a firm’s market power sufficiently. 22. See Dudley (2003).

8. We focus on labor and ignore capital and raw material costs to simplify 23. See Federal Open Market Committee (1996), page 11. our exposition. Labor costs alone account for about two-thirds of the cost of producing goods and services. 24. See Ip (2003, June 27 and August 15).

9. See Goodfriend (2002) for an exposition of the mechanics of interest rate 25. McCallum (2004) makes a related point. policy geared to maintaining price stability in a new synthesis model. Woodford (2003) presents an extensive treatment of interest rate policy. 26. While the core PCE, the Fed’s preferred inflation measure internally, Clarida, Gali, and Gertler (1999) provides a useful survey. We ignore the seems a straightforward choice for the index on which to base its target zero-bound constraint on interest rate policy in this section, assuming, measure, the better-known consumer price index could be used instead. in effect, that the shocks are small enough that the zero-bound con- Our framework suggests that the Fed should target a core inflation index straint never binds. that closely reflects sticky prices set by monopolistically competitive firms.

10. Optimism or pessimism regarding job prospects, profitable investment 27. This repeats a point made by Broaddus at the January 1995 FOMC opportunities, taxes, and war, for example, would all affect future meeting. See Federal Open Market Committee (1995), page 41. income prospects. 28. The output gap measures aggregate output relative to an estimated 11. Weak productivity growth, however, was only part of the story in the potential level of output consistent with price stability. The employment 1970s: inflation rose long before the extended productivity slowdown gap measures aggregate employment relative to an estimated level of began in 1974 and fell briefly thereafter, before rising again in 1978. employment believed to be consistent with price stability.

12. See Goodfriend (1993). See Orphanides and Williams (2004) for a 29. See, for example, Orphanides (2002). quantitative, theoretical analysis of inflation scares in a model of perpetual learning. 30. McCallum (2001) discusses conceptual and operational problems involved in measuring employment gaps and output gaps, and argues 13. Potential GDP refers to the path of output consistent with the that monetary policy should not respond strongly to such gaps in its maintenance of price stability. monetary policy rule.

14. Kennedy (1999) describes U.S. economic policies in the 1930s as a 31. These words were employed initially in the policy statement following collection of market interventions taken to support favored sectors of the August 2003 FOMC meeting. See Ip (2003,August 13). The FOMC the economy. Cole and Ohanian (2001) model these interventions and dropped the “considerable period”language at its January 2004 meeting, show quantitatively that they can explain the persistence of the Great saying instead that it could be “patient”in raising interest rates. Depression in the United States. 32. Our recommendation is consistent with evidence presented in Kohn 15. It is worth pointing out that credibility for price stability is also threat- and Sack (2003) that greater clarity in the Fed’s statements about the ened when Fed participation in foreign exchange operations with the economic outlook would improve monetary policy. Treasury creates doubt about whether monetary policy will support domestic or international objectives. See Broaddus and Goodfriend (1996). FRB_Text_Printer 8.625 6/9/04 8:53 AM Page 25

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